What Is Fiscal Policy and Its Types? | How Does It Affect the Economy

An economy can be significantly impacted by the financial decisions made by households. For instance, households may decide to spend more and save less, which may result in additional jobs, investments, and eventually profits. Likewise, the Corporations’ investment choices can significantly affect the actual on business profitability and the economy. However, individual businesses rarely have a significant impact on economy independently; the spending choices made by a single household will barely affect the economy as a whole.

On the other hand, for two primary reasons, government policies can significantly affect even the biggest and most advanced economies. First, in the majority of developed economies, a sizable fraction of the workforce is employed by the public sector, which also typically accounts for a sizable amount of economic spending. Second, in the global debt markets, governments are the biggest borrowers. In the end, government policy is communicated through its borrowing and spending practices. So, this communication of government through its borrowing and spending practices, are studied in the fiscal policy, in which we will look into the topics related to our economic spendings and borrowings.

What is fiscal policy?

Fiscal policy is a fundamental tool used by a government to guide the overall direction of a country’s economy. In simple terms, fiscal policy refers to the government’s decisions about taxation and spending. It involves the use of government spending and changing tax revenue to affect certain aspects of the economy, such as the overall level of aggregate demand. Fiscal policy tools seek to achieve or maintain an economy on a path of positive, stable growth with low inflation. The government’s treasury department or finance ministry usually oversees fiscal policy, which is coordinated with central banks’ control over monetary policy.

Types of Fiscal Policy

Expansionary Fiscal Policy:

A dynamic plan used by the government to speed up economic growth when it is deemed too slow or stagnant is expansionary fiscal policy. The main goal of this strategy is to boost growth by increasing the money flowing into the economy. This is mainly achieved through two simultaneous actions: reducing tax revenue from individuals and businesses and increasing government spending on public projects and programs. By lowering taxes, the government provides firms and consumers with more disposable income, encouraging them to invest and spend more. At the same time, the government creates jobs and hires private companies by increasing its spending on areas like infrastructure, healthcare, and education. These actions together raise the overall demand for goods and services in the economy. Businesses then increase their output to meet the higher demand, leading to more hiring and investments in capacity. This ultimately creates a cycle of economic growth and recovery, aiming to reduce unemployment and restore strong economic growth.

• Purpose: Used during recessions or periods of low economic growth to boost demand, create jobs, and increase output.
• Tools:
  • Increased public spending on infrastructure, education, or healthcare.
  • Tax cuts to increase disposable income for consumers and businesses.
• Example: During the 2008 financial crisis, many governments implemented stimulus packages, such as the U.S. American Recovery and Reinvestment Act, to boost demand.

Contractionary Fiscal Policy:

Contractionary fiscal policy is a government strategy intended to slow down an economy that is growing too fast and may be overheating. The main goal of this policy is to fight rising inflation, which is the overall increase in prices when too much money is chasing too few goods. The government achieves this cooling effect through two main actions: raising taxes and cutting its own spending. By increasing taxes, the government limits the disposable income available to consumers and businesses, reducing their ability to spend and invest. At the same time, by decreasing its spending on public projects and services, the government takes away a source of demand from the economy. Together, these measures lower the total amount of money in circulation and cut the overall demand for goods and services. This decrease in demand helps relieve some of the pressure on prices, stabilizing the economy and bringing inflation under control. However, this approach may also result in slower economic growth and an increase in unemployment as an unavoidable consequence.

• Purpose: Used to control inflation, reduce budget deficits, or stabilize an economy growing too quickly.
• Tools:
  • Reduced government expenditure on public projects.
  • Higher taxes to decrease consumer and business spending.
• Example: A government might raise income taxes or cut public sector wages to cool down an economy experiencing high inflation.

Neutral Fiscal Policy:

Neutral fiscal policy refers to a government’s budget approach where its spending is fully funded by the tax revenue it collects. This results in a balanced budget. In this situation, the government’s fiscal actions do not aim to actively boost or slow down the overall economy. The effect of the government’s budget is considered neutral because it does not add extra demand or remove any significant amount of existing demand. The total money the government takes from the economy through taxes is roughly equal to what it spends back into the economy. This policy is usually used when an economy is stable and healthy on its own, with satisfactory growth and stable prices. In such cases, the government sees no urgent need to intervene with expansionary or contractionary measures and simply aims to maintain the economic status quo.

• Purpose: Used when the economy is stable, neither requiring stimulation nor restraint.
• Tools:
  • Balanced budgets with no significant changes in spending or taxation.
• Example: A government maintaining steady spending on public services without major tax hikes or cuts during periods of stable growth.

How Fiscal Policy Affects the Economy?

Aggregate Demand:

Aggregate demand is the total amount of goods and services that everyone in a country, consumers, businesses, the government, and foreign buyers, wants to buy at a specific price level. You can think of it as the economy’s total spending power. Fiscal policy is the main tool the government uses to directly affect this aggregate demand. It does this by changing its spending and tax levels. The central idea is that by increasing or decreasing (Expansionary and contractionary fiscal policy) this total demand, the government can guide the economy toward stability.

• Companies and consumers might invest in more goods and services if government spending or tax reductions put money into the system. Expansionary fiscal policy is aimed at increasing aggregate demand.
• A contractionary fiscal policy is meant to reduce demand by withdrawing money through lesser spending or higher taxation. It might end up raising the cost of doing businesses and thereby slow economic activity.

Economic Growth:

It is usual for economic growth to be one of the targets of expansionary fiscal measures. Fiscal policy affect on economic growth by directly affecting the crucial factors driving production and consumption in a country. With the shift of taxation and spending, the government sets out to either speed up or slow down the economy’s workings.

• Expansionary policies can really help boost GDP growth by ramping up demand for goods and services, which in turn encourages businesses to increase their production.
• Contractionary policies might slow down growth in the short run, but they can help avoid unsustainable booms or asset bubbles in the long run.

Employment:

Employment plays a crucial role in fiscal policy, as the choices the government makes about spending and taxes have a direct impact on job creation and loss. This, in turn, sends wave throughout the entire economy. The link between these factors primarily operates through aggregate demand, which represents the total spending power available in the economy.

• When the government boosts spending or cuts taxes as part of an expansionary policy, it can help create jobs and lower unemployment rates.
• Contractionary policies might result in job losses in the public sector or a dip in demand from the private sector, which could lead to a rise in unemployment in the short run.

Inflation:

Inflation, which refers to the overall increase in the prices of goods and services, is a key focus for fiscal policy aimed at keeping it in check. The way the government handles spending and taxes has a direct impact on inflation, making this management essential for ensuring economic stability.

• Expansionary fiscal policy can push inflation higher if demand outstrips supply, leading to rising prices.
• Contractionary fiscal policy can help keep inflation in check by controlling demand and stabilizing prices.

Government Debt and Deficits:

Government debt and deficits aren’t the tools of policy themselves; instead, they are the possible results of implementing fiscal policy, and they can have serious long-term effects on the overall health of the economy. A budget deficit happens in a given year when the government spends more than it brings in through taxes. To make up for this gap, the government usually borrows money by issuing bonds. The total government debt is essentially the sum of all past annual deficits, adjusted for any surpluses.

• Expansionary policies can sometimes create budget deficits when spending outpaces tax revenue, which in turn raises public debt.
• Contractionary policies can help shrink those deficits and debt by boosting revenue or cutting back on spending, ultimately leading to better fiscal health.

Income Distribution:

Income distribution is all about how a country’s total income is shared among its people, ranging from those who earn the least to those who earn the most. One of the most effective tools at a government’s disposal to shape this distribution is fiscal policy. The degree of equality or inequality in income distribution can have significant impacts on the overall health and stability of the economy.

• Progressive taxation and focused government spending, like investing in social programs, can help bridge the income inequality gap.
• Regressive tax policies or cuts to social services can actually make those income gaps even wider.

Crowding Out and Crowding In:

Crowding Out and Crowding In represent two contrasting effects that can arise from expansionary fiscal policy. This happens when the government spends more than it brings in and needs to borrow to cover the deficit. Essentially, these terms illustrate how government borrowing can either negatively impact or positively influence private sector investment, which is vital for sustained economic growth.

• Crowding Out: When the government borrows more money to support expansionary policies, it can lead to higher interest rates, which in turn can discourage private investment.
• Crowding In: Government investment in infrastructure or education can really boost private sector investment by fostering a positive economic climate.

Multiplier Effect:

The fiscal multiplier plays a crucial role in macroeconomics because it helps us understand how much output shifts in response to changes in government spending or taxation. When the government increases spending, those who receive this extra money usually save a portion of it, specifically (1- c) of each additional dollar they earn, where c represents the marginal propensity to consume (MPC) of that extra income.

• Fiscal policy can have a multiplier effect, where an initial increase in government spending or tax cuts leads to a larger increase in economic output. For example, $1 of government spending might generate $1.5–$2 in economic activity as businesses and consumers spend the additional income.

Conclusion

Fiscal policy plays a vital role in steering the economy. When times are tough, expansionary policies can help spark growth, while contractionary policies are useful for keeping inflation in check during prosperous periods. Neutral policies, on the other hand, aim to keep everything stable. That said, how effective fiscal policy is really hinges on how well it’s designed, when it’s implemented, and the overall economic landscape. If there are mistakes, like borrowing too much or spending in the wrong areas, it can lead to problems such as soaring debt or inflation.

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